What Are the Tax Benefits of Annuities?

Developing a retirement savings plan can help ensure that you have enough money to pay your living expenses once you stop working. While there are different avenues you might explore to reach your savings goal, annuities are often overlooked because they're somewhat complex by nature. But while annuities aren't right for everyone, they do offer some key benefits -- namely, the ability to grow your money on a tax-deferred basis and generate a reliable income steam once you're older. It pays to learn more about the annuity tax benefits that could set you up for a more financially secure retirement.

Tax advantages of annuities

Perhaps the greatest benefit of annuities is the ability to take a large sum of money, invest it for the future, and avoid paying taxes along the way. While the money you contribute to an annuity isn't tax-free, once it's in there, it can grow on a tax-deferred basis, which means you won't pay any taxes on investment gains along the way. In this regard, annuities are similar to popular retirement savings options like IRAs and 401(k)s.

The primary difference between annuities and IRAs or 401(k)s is that you don't have to worry about annual contribution limits. Currently, workers under 50 can contribute up to $5,500 a year to an IRA and $18,000 a year to a 401(k). Those who are 50 or older get a catch-up allowance that increases those limits to $6,500 and $24,000, respectively. But for higher earners or those who are simply good savers, these limits can be restrictive.

If you're looking to save more for retirement than what the current annual IRA or 401(k) limits allow for, you might stick the rest of your money into a traditional, taxable brokerage account. And while that might help you grow your wealth, it won't shield you from taxes on investment gains along the way. With an annuity, however, you can contribute as much as you'd like and take advantage of tax-deferred growth.

Annuity withdrawals in retirement

While the money placed in an annuity gets to grow on a tax-deferred basis, withdrawals aren't necessarily tax-free. Annuities are typically taxed on what's considered a last-in, first-out basis. When you first withdraw funds from an annuity, the money that comes out is considered earnings and taxed as ordinary income. But once the value of your annuity falls below the amount you paid into it initially, you can take withdrawals tax-free.

Another thing to keep in mind about annuities is that, unlike IRAs and 401(k)s, annuities typically don't impose minimum required distributions. With a traditional IRA or 401(k), you're required to start taking money out of your account once you turn 70 1/2, and failing to do so could result in a 50% penalty on the amount you should've withdrawn. Taking your required minimum distribution not only subjects you to extra taxes, but also limits your ability to grow your wealth -- because if you have less money sitting in your account, you won't earn as much on it. But as long as you don't hold your annuity in an IRA, you won't be subject to the same required minimum distributions. (Keep in mind that there are limited benefits of holding an annuity within an IRA in the first place, since money in an IRA already gets tax-deferred growth.)

Of course, annuities also have their drawbacks. Like IRAs and 401(k)s, if you take money out of an annuity prior to reaching age 59 1/2, you'll pay a 10% early withdrawal penalty. Furthermore, annuities typically come with annual fees that can eat away at your returns. But not all annuities are created equal, so if you're looking for a way to save for retirement and have already maxed out your IRA or 401(k) contribution for the year, it pays to see whether an annuity offers the right solution for you.

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